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The Global Economy
Class Notes
Money and Banking
Revised: Spring 2015
This note is about the nuts and bolts of monetary policy. It builds on chapter 10 of
the manuscript entitled “Macroeconomics: A Modern Perspective,” by Tom Cooley
and Lee Ohanian.
What is money?
Astandard way to begin discussions of money is to try to define what it is. This is
somewhat difficult to do because historically many things have been used as money
- shells, beads, cigarettes, pieces of paper. What characteristics make any of these
suitable as a form of money? One way to think about this is to define money in terms
of the services it provides. Money is an asset. An asset is something that serves as a
store of value. This means that it can be used as a way of transferring consumption
between periods. But, lots of things, stocks, bonds, real estate, can and do fulfill that
function. Money is really quite different from other assets because it provides another
important service - it serves as a medium of exchange. The medium of exchange role
implies that it is freely exchanged for goods and services and it has wide acceptance
and (generally) well understood value. Another service that money provides is that
it serves as a unit of account. The role of unit of account means that when we talk
about the value of other assets or consumption goods we use monetary units as a
standard way of denominating them.
How does money come into being and why are people willing to accept some forms
of money? We know that different forms of money have evolved naturally in many
societies. One example that is often cited is that cigarettes became used as a form
of money in prisoner of war camps during World War II. They are also often used as
a form of money in U.S. prisons. What problems does the existence of an accepted
form of money solve? The easiest way to understand this is to imagine a simple
economy in which individuals all specialize in the production of a single good. Some
grow wheat, some harvest wood, some raise chickens and some educate the young.
The educators and wood harvesters have to eat, the food producers need wood and
need to educate their young and so on. People benefit from transacting with one
another. But if this were a pure barter world, then transactions could only take place
when we found someone who offered in trade something we desire and who desired
that which we produce. This is called the double coincidence of wants. The point
is that transacting in such a world would be very inefficient. Suppose, instead that
there were some accepted medium of exchange. It need not be anything with intrinsic
Money and Banking 2
value. It could be stones of a certain size and shape, or pieces of paper embossed with
a picture of long dead politicians. All that is required is that everyone agree that it is
the medium of exchange and agree on its relative value. In this world, educators could
now exchange education services for that type of money and use it to purchase wheat
and wood without worrying about whether the producers of wheat and woods that
he encountered had any need for education services. The acceptance of a medium of
exchange thus facilitates transactions in the society because it removes an important
impediment to economic activity. That is why money arises naturally. Now, lets talk
about how we measure it.
Because the distinguishing characteristic of money is its use to facilitate transactions,
a definition of money should include assets commonly used to facilitate transactions
and should exclude assets that are difficult or impossible to use for transactions. My
house, for example, is an asset and a store of value, but it would be difficult to use for
transactions because it is not divisible and there may be a lot of uncertainty about
its value. Unfortunately, the distinction between these types of assets is not always
very sharp and it has changed over time because of technology and improved access
to information. Accordingly, there is not a unique empirical definition of money.
Rather, there are several measures that we use and each of them tends to be useful
for some purposes. In what follows we will discuss the monetary measures that are
tracked in the United States. Although the discussion is specific to the United States
these definitions tend to be fairly universally applied.
The narrowest measure of the money supply counts only government–issued currency
held by the non-bank public. This aggregate is included in all broader definitions of
money and is called the currency component of the money supply.
AsomewhatbroaderdefinitionofmoneyisknownasM1. Itincludes currency held by
the non-bank public, travelers checks, and checkable deposits at commercial banks. A
still broader definition of the money supply, known as M2, includes M1 plus savings
deposits, small time deposits (under $100,000), money market mutual fund shares
(MMMFs) held by the public, money market deposit accounts (MMDAs), overnight
Eurodollar deposits in foreign branches of U.S. banks, and overnight repurchase agree-
ments whereby a bank sells a security overnight to a non-bank institution. A still
broader definition, M3, includes M2 plus large certificates of deposit and MMMFs
held by institutions. When mentioning the money supply, most people have M2 in
mind. For our purposes, however, the exact definition is not crucial.
Table 1 shows the components of the various measures of money as of the start of
November 2014 (figures are in billions of dollars). For comparison, nominal GDP in
2013 was about $16,768 billion. It is worth noting that what you might commonly
think of as money, currency, is only a small fraction of these broader measures. But
it is clear that all of these other components of money are available, to some degree
or other, for transactions.
Money and Banking 3
M1 2,900.6
Currency 1,234.3
Travelers Checks 3.0
Demand Deposits 1,175.9
Other Checkable Deposits 487.4
M2 11,488.3
Table 1: United States - Measures of Money Supply in November 2014 – Seasonally
adjusted.
Managing the money supply
In the United States and in most other countries, it is the Central Bank that is charged
with the task of controlling the money supply. The U.S. central bank is called the
Federal Reserve. It was established in 1913 by an act of congress and has responsibility
for regulating banks and, most importantly, for formulating and conducting monetary
policy. The Federal Reserve is an independent central bank. This means that it
formulates and implements policy independently of the government in power. This
arrangement is not true of other countries and we will discuss the importance of this
independence later on. There are 12 regional Federal Reserve Banks and a Board
of Governors of the Federal Reserve System that resides in Washington D.C.. Since
the 1930’s power over monetary policy has been concentrated in the Federal Reserve
Board and a group called the Federal Open Market Committee (FOMC). The FOMC
consists of (i) the seven Governors of the Federal Reserve System, who are appointed
by POTUS for staggered 14 year terms; (ii) the Chairman, currently Janet Yellen,
who serves for a four year term; (iii) five of the regional bank presidents who serve
on a rotating basis. The FOMC meets every six weeks.
The Federal Reserve has no direct control of the money supply, but it influences
its volume via the management of the monetary base, also known as high-powered
money. The monetary base includes currency held by the non–bank public plus
reserves held by commercial banks as backing for their deposit liabilities. Banks
hold reserves in two forms, vault cash (piles of banknotes held in the basement) and
reserve deposits maintained at one of the twelve regional Federal Reserve Banks. The
term “monetary policy” refers to the actions undertaken by the Federal Reserve to
influence the availability of money to the public. We will illustrate such actions with
some detail. Before we do that, it will be useful to describe the features of a banking
system where deposits must be backed by reserves.
Banks hold reserves for two reasons. First, because they must be able to honor
demandsforcashbytheirdepositors. Second, intheU.S. andinmanyothercountries,
Money and Banking 4
they are required to maintain certain reserves. Whenever the reserve requirement is
less than 100%, we have a fractional-reserve banking system. Variations in reserve
requirements have at various times been an important tool of monetary policy. How
those variations affect the economy is an important topic that we will discuss further.
The significance of the fact that banks only have to keep fractional reserves is that
banks can use a dollar of reserves to back several dollars of deposits. We now examine
how commercial banks use additional reserves to create deposits.
The table below illustrates a highly simplified balance sheet of a commercial bank.
The major asset categories are reserves, earning assets, and buildings and facilities.
The two main types of earning assets are loans made by the bank and securities
(mainly government debt) held by the bank. The bank’s major liability is deposits
held for its customers.
Bank Balance Sheet
Assets Liabilities
Reserves Deposits
Required
Excess
Earning Assets
Securities
Loans
Buildings, etc. Net Worth
Suppose we decided to start a student bank, to be run by the association of students.
Initially all items on the balance sheet of Student Bank are zero. (For simplicity,
we do not explicitly show net worth, securities, buildings and facilities, etc., on the
balance sheet.) Now suppose that our customers deposit $1,000,000 of currency in
the Bank (these are well-to-do students or there are lots of them!). This currency
(now vault cash) counts as a part of Student Bank’s reserves. Suppose that the only
regulation this bank faces is that it must maintain a certain fraction of its deposit as
reserve. If the required reserve ratio is 0.2, Student Bank now has required reserves
of $200 and excess reserves of $800. The following table shows the bank’s new balance
sheet. When the interest it earns on reserves is lower than the opportunity cost, the
bank wishes to convert its excess reserves into earning assets.
Student Bank
Assets(000’s) Liabilities (000’s)
Reserves 1,000 Deposits 1,000
Required 200
Excess 800
Loans 0
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